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Just like everyone else in the financial markets over the last week or so I have become the world-famous specialist on Japanese flows (!)*. I have heard a lot of more or less plausible stories and when I was trying to digest all the noise, I couldn’t help but think about “Nothing As It Seems” by Pearl Jam:

Occupations overthrown, a whisper through a megaphone It’s nothing as it seems, the little that he needs, it’s home The little that he sees, is nothing he concedes, it’s home And all that he frees, a little bittersweet, it’s home It’s nothing as it seems, the little that you see, it’s home…

I am not certain what is going to happen with the wall of money that is seemingly coming from Japan, but I know that there’s a remarkable amount of superficial analysis, which I would like to comment on.

1. The Japanese carry trade will continue as the BoJ prints more.

According to estimates by Daiwa net issuance of JGBs after stripping BoJ purchases will be -26trn yen. This is around 5% of GDP, which is a pretty monstrous amount. This naturally makes people’s imagination go into overdrive, particularly as we’re talking about the country with decent carry-trading history. But there is one problem with such an approach. Carry trade was Japan’s response to the lack of returns in the local market. Bond yields have been ridiculously low and the stock exchange was still suffering as zombie-banks kept dragging it (and the economy) lower. Now, do you think this situation has not changed even a bit? We may be agreeing or disagreeing with what the BoJ is doing but investors (particularly retail) could be excused for e.g. thinking that the Nikkei will double this year. This is particularly the case as what the BoJ seems to have orchestrated is a fantastic opportunity for the Japanese banks to cash in on their available-for-sale JGB portfolios. So answer yourself this question – is it so entirely obvious that Mrs Watanabe continues buying AUDJPY (annual yield of 3.2%), ZARJPY (annual yield 5.4%) or MXNJPY (annual yield 4%)? Granted, these and many other currencies will continue to constitute a very important part of the Japanese investment portfolio but pretending that the investment backdrop in Japan has not changed is naive in my opinion.

2. The big yen move has only just begun.

Currently various forecasters are trying to come up with the most bearish view for the yen. I have already seen 120/USD but admittedly I do not pay much attention to that stuff. But try to think who has so far made money on the yen debasement? If you don’t know then try to get a hold of the HSBC hedge fund report to see that the vast majority of macro funds have caught at least a part of this move. And because selling the yen is seemingly such a no-brainer**, not being in the trade is a big career-risk for many. In some sense, macro hedge funds cannot afford to miss another leg in the yen move (if there is one). But in the greater scheme of things this is just noise. Don’t forget that the Japanese economy has just become at least 30% cheaper. And we are talking about a bunch of historically deadly innovative companies who have managed to keep their place in the global market place against all odds.

Goldman has recently produced a study showing that the country with the most similar exports composition to Japan’s is… Germany. It is already very much visible it the underperformance of the DAX, in my opinion. Personally I prefer Mercedes over Toyota but at a 25% discount I know I would change my mind.

My thinking is as follows: if this yen depreciation and the crowding out of the Japanese banks from the JGB market is persistent then Japan has every chance to become the champion of the global trade again. And if so, why on earth would I be buying GBPJPY or AUDJPY?

Let me give you another example: If you have been selling the yen and buying the South African rand consistently in the last five years then only last week did you break even on your average spot level. Sure, you got some coupons in between but it cannot be ruled out that investors who have been buying the ZAR against the JPY will just take this as an opportunity to close the position after being bailed out by the BoJ.

3. Banks will invest abroad.

This bit I find preposterous. I have mentioned above that banks may have just been given a lifeline by the BoJ and they will be able to off-load their available for-sale portfolios at a significant profit. What they do with the cash next is anyone’s guess but banks are not really in the business of punting on currency markets with their balance sheets. Believe it or not but even when GS recommends buying EURUSD, it’s not like Goldman’s treasury shifts all its money to Europe. Banks operate in the “LIBOR+” world. They are happy to take exposure to foreign bonds but it is usually done on an asset swap basis. Below are a few bonds that I just looked up on Bloomberg and how they compare when swapped to JPY.

T 2 02/15/23 78bp

SAGB6.75 03/31/21 #R208 68bp

MBONO6.5 06/09/22 68bp

POLGB 4 10/25/23 10bp

TURKGB8.5 09/14/22 36bp

As you can see those differences are not huge and definitely not big enough to make emerging markets irresistible. Additionally, there’s a perverse effect of what’s been going on in the JGB market lately. The chart below shows a crude calculation of VaR for 10y JGB futures since 2000.

A chart of the yield volatility is looking even scarier, which – paradoxically – could bring the Japanese banks into a risk-reduction mode as no one can bear such wild swings of the profit and loss account. And adding Brazilian assets to the portfolio doesn’t help much.

Yes they will. The same way as they have in the past. Well, maybe with a bit bigger size but it’s far from being certain at the moment. If it’s the yen weakness they’re after then I suppose buying the USD will do (without adding an extra layer of volatility between the USD and some other currency). And if they don’t think the yen weakens much from here then why would they accelerate foreign buying in the first place?

This brings us to the last point I would like to make. As much as in previous years the Japanese investments abroad were driven by expectations of superior returns outside of the country, we are now talking about the expected yen weakness. In my opinion this changes the structure of investors taking advantage of the move and I believe that it will be the foreigners shorting the yen, rather than the locals. This, at least in the near term, makes it a tactical, rather than a structural trade.

So these were my views on the whole situation. I don’t have any concrete recommendations this time but I just don’t like how one-sided the discussion has become. And if I’m wrong then… well… listening to Eddie Vedder while writing this post definitely made it worth my while.

* not sure how to stress that I am being ironic, but I have noticed that subtitled movies on Sky have (!) at the end of sarcastic sentences.

** I have always thought that no-brainers are for people without brains but somehow this definition hasn’t become mainstream.

One of the basic ideas of investing in emerging markets is that whatever it is you are going to make by holding EM assets will be boosted by the currency return. For the most part, currencies in emerging markets have beaten their respective forwards. To take a real life example, you can today sell USDZAR 1y forward at almost 9.50 expecting the spot to fix much below that in 1 year’s time. Sure, sometimes you would get hosed (particularly on the rand) but in principle it has been a winning strategy over the longer term. Just see never-ending EM bullish comments from Mark Mobius or Jim O’Neill. Happy days, at least for them…

Such a phenomenon has a strong backing in the macroeconomic theory, which tells us that countries experiencing higher growth rates should see their real effective exchange rates appreciating. Of course this will happen through a combination of nominal appreciation and higher inflation but as long as the particular USD/EM cross doesn’t go up, investors should be happy.

But carry is not only about beating the forward in the FX market. There used to be a much powerful, yet less known set of transactions aimed at generating carry. I am talking about buying short term debt issued by emerging markets and funding it in the FX swap market. This transaction used to be loved by banks – they would use their cheap USDs, convert them to an emerging currency in an FX swap and buy the debt, mostly up to 1y maturity. This had three key benefits to emerging markets:

provided a steady supply of hard currencies to the economy (financing of the current account deficit),

increased the demand for government debt (financing of the fiscal deficit),

was pretty stable as banks could withstand a lot of volatility by keeping assets in hold-to-maturity portfolios.

If you think of it, the first two points must have significantly contributed to superior growth rates in many emerging economies, thus enabling the “beat the forward” crowd make money.

Interestingly, right after the financial crisis of 2008/2009, this activity increased. Banks suddenly got access to super cheap funding from monetary authorities and the Basel committee had not woken up yet to throw new regulations and capital/liquidity requirements. At the same time, cross-currency basis widened considerably. This meant that “some currencies are more equal than others“. Or put differently, as much as before the crisis the Mexican peso or the Polish zloty would be trading at par with the USD in the money market, having the dollars right after the most acute phase of the financial crisis passed was a huge advantage. Banks (and some hedge funds via a structure called Total Return Swap) made a lot of money on that. A LOT…

But then the access to USDs became so universal that the greenback ceased to trade at such a premium and, of course, the new regulations came making it exceptionally difficult to use banks’ balance sheets for carry trades in emerging markets. But fair enough, maybe this sort of money-making method should not really be used by banks.

There are, however, pretty wide implications. I have already hinted that the described activity of banks was one of the important reasons why EM growth (and consequently currencies) outperformed. Also recall that the funding achieved by emerging economies had been pretty stable until the changes came. So with this in mind, does it still make sense to talk about carry trades in emerging economies?

I did a quick exercise analysing how long it takes to wipe out the quarterly carry in Mexico and South Africa (I have chosen them at random). I basically looked at average daily depreciation over the course of a month and compared that to the quarterly carry. In both ZAR and MXN I got a similar result, i.e. 2.6 days. Imagine buying the rand and the peso for the carry on Monday morning because you think carry trades will perform. By the time you return from lunch on Wednesday your quarterly carry could be wiped out. Puts things in perspective, doesn’t it?

How to trade this? I know I have committed to giving some trading clues after my posts but here a better question to ask is how NOT to trade this. It may sound like a cliche but seriously, if someone tells you to buy a currency “because the carry is good”, just show them the door. Secondly, I would caution against assuming that volatility will increase as people get stopped out on carry positions in emerging markets more often. The sad truth may be that as much as many FX-focused banks would hate it, speculative activity in EMFX could remain quite low, in which case it will be economic cycles determining exchange rates. And trends are usually associated with low implied volatility…

When you look at celebrity analysts and investors of late, you will have to conclude that we’re dealing with confirmation bias of horrendous proportions.
It is very easy to be permanently bullish, particularly in the equity business and the bears have it tough because in order to be remembered they need to be good at timing. Or at least they have to be able to survive with their call in the media for an extended period. A good example of the former is Mr Paulson and his one-trick subprime pony. As far as the latter is concerned you don’t need to look past Nouriel Roubini who called a completely different crisis (remember the US current account and twin deficits?) a long time before it never-happened and yet has somehow been enshrined as a guru. Sure, there are people who called it right and for right reasons but they’re less present in the media because they are honest enough to admit that sometimes your views are actually going to be a bit more boring than “the end is nigh, sell everything”.
I must say that forecasting bearish scenarios is remarkably tempting. Not only can you stand out in a crowd but the potential payout is humongous. I think many people at some level admire Nassim Taleb despite the fact that he’s ability to make money trading has been grossly exaggerated, to be polite.
So every now and then we hear people who call “wolf” and hope that they 1) appear prudent and 2) cheaply expose themselves to a significant tail risk (which in this case should be called a “tail chance”).
Why am I writing about this? Well, because I’m sick and tired of people pointing out how ridiculously low the VIX is. Yes, the VIX is very low and stable but it has nothing to do with the market perception of risk. Believe me, everyone is aware that this thing can blow and crucify markets. The VIX is low because it gives you carry.
If you’ve ever been trained in the theory of options you may recall the gamma-theta trade-off. This basically means that you own the right to capitalise on movement in the underlying variable and you pay for this right with theta, i.e. time decay. Thus, selling options is simply yet another way of getting carry. I know many of you will find it pretty basic but I still believe it needs stressing.
USTs are probably too expensive, all medium-term risks considered. But so what? Shorting them with cost you a fortune. Same with VIX. Yes, it severely understates the risks but the cost of holding it is not negligible. In fact, it is even higher than just paying for implied volatility. I would argue it’s double that because opportunity cost of buying the VIX is… selling it!
The same applies to FX options and any other instrument. We are in an environment where you have to have pretty damn good reasons not to be in carry-positive trades. At the end of the day fund managers charge, say, 1% and every day that passes by without them clocking the carry brings them closer to dreaded outflows. Unless of course they time their shorts well but for that you really need a little more than “this stuff is at all time lows”.
My (relatively short) experience in the market suggests that on aggregate buying options doesn’t pay off. Otherwise bank option desks would’ve ceased to exist by now. This is very similar to buying car insurance – as a society we get screwed (see insurance companies’ profits) but there’s always a guy who had his car stolen and cashed out.
Don’t get me wrong, I’m not calling for being engaged in mindless carry trades. In fact I’ve been spending most of the time lately trying to figure out smart shorts (hence my recent focus on linkers). Buying VIX is definitely not one of them even if it eventually covers one lucky analyst in glory.
Oh yes, didn’t I say I envy all those guys mentioned at the beginning…?

PS. I am in some obscure place on the continent so can’t really do much charting. Will improve that from next week onwards.